The retirement years: Who is going to pay?

Analysis | 20 May 2015

Our researchers weigh up tax hikes against pension cuts

Australia's latest Intergenerational Report (IGR) – the fourth since 2002 – leaves little doubt about the immense challenges we face from a population that is both changing and growing.

Not only are we living longer but there is also a demographic transformation occurring as the first of the baby boomers march beyond the official pension age of 65.

According to the report's projections, the number of Australians aged 65 years and over will more than double from present levels by 2054-55.

The number and proportion of Australians aged 85 years and over will grow even more rapidly. In 1974-75, this age group represented less than 1% of the population, or around 80,000 people. In 2054-55, it is projected that 4.9% of the population, or nearly two million Australians, will be aged 85 years and over.

The 2015 IGR also revised upward the previous estimates for the total population, which is expected to reach almost 40 million in 2054-55, with the growth supported by higher net overseas immigration than was assumed in past reports.

Such changes in the size and age structure of the population during the next 40 years will have a fundamental impact on the economy, income growth and ultimately living standards.

George Kudrna, a research fellow at the Centre of Excellence in Population Ageing Research (CEPAR) at UNSW Business School, says the demographic transition towards population ageing can be expected to lead to decreases in aggregate labour market activity, resulting in a contraction in production and lower living standards compared to a world with no demographic change.

Population ageing will also place increasing demands on government spending in the form of old-age related programs, including health, aged care and pensions.

The 2015 IGR projects that the spending on Age and Services Pensions will increase from 2.9% of GDP to 3.6% of GDP by 2054-55 under the "currently legislated" scenario, which includes increases in the pension age to 67 and the incremental lifting of the superannuation guarantee rate to 12%.

The aged care expenditures are projected to almost double during that period, contributing to an underlying fiscal deficit of 6% of GDP in 2054-55.

'Taxing either consumption or income results in opposing effects on the economy and welfare across different income groups of households'
GEORGE KUDRNA

Behavioural responses

Kudrna's research paper, The Dynamic Fiscal Effects of Demographic Shift: The Case of Australia, co-authored by UNSW Business School scientia professor Alan Woodland and ANU senior lecturer Chung Tran, also quantifies the fiscal challenges caused by demographic shift.

But an important difference from the IGR is that this CEPAR paper uses a general equilibrium model that incorporates behavioural responses by households to ageing.

According to Kudrna, in projecting the spending impact on an ageing population neither the IGR, nor an earlier report by the Productivity Commission on an Ageing Australia, took direct account of behavioural responses to population ageing.

"You would expect that people will respond to increased longevity by working and saving more during their life cycle," Kudrna says.

"We find that there are significant projection errors when abstracting from modelling such behavioural responses, which play an important role in explaining the impact of population ageing on the economy."

The authors also decompose the dynamic fiscal effect of population ageing by two sources of ageing – increased longevity and lower fertility – to determine their relative importance in the Australian context.

Their simulation results show that projected future changes in longevity are the main driving force behind such a pressing fiscal challenge.

Policy options

Australia is recognised as one of few countries well placed to cope with population ageing pressure. Our retirement income policy features a low-cost, means-tested public pension and a privately managed, pre-funded superannuation scheme.

Also, we don't have to pay any specific labour income or payroll taxes, which in other developed countries are used to finance old-age and disability pensions.

There is, however, no doubt that the government will face pressing fiscal challenges from the projected increases in the old-age related spending programs, which need addressing.

Increasing the pension access age to 67 by 2023 – and possibly to 70 – has been an early response. Reduced spending on other areas such as defence has been raised as another option.

But what about cuts to the pension or increased taxes as policy options to mitigate the anticipated financial pressure? The IGR provides little guidance on who bears the costs of the proposed policies.

In their recent working paper, Facing Demographic Challenges: Pensions Cuts or Tax Hikes, Kudrna, Tran and Woodland investigate the macroeconomic and welfare implications of the two fiscal policy options.

One of the main findings indicates that while both pension cuts and tax hikes achieve the same fiscal goal, the macroeconomic and welfare outcomes of the two policy options differ significantly.

'There should be no surprise that older people receiving the pension and those approaching the pension access age do not want their benefits cut and would prefer a tax hike to fund government spending commitments'
GEORGE KUDRNA

Pension cuts

"There should be no surprise that older people receiving the pension and those approaching the pension access age do not want their benefits cut and would prefer a tax hike to fund government spending commitments," says Kudrna.

The authors consider three possible changes to pension benefits – a higher pension access age, a reduced maximum pension, and an increased taper of the pension income test (the rate at which the pension is withdrawn) – and study the effects on welfare of households distinguished by age and income type.

Kudrna notes significant differences in the distributional welfare implications arising from the three options.

The higher pension age policy will have no impact on higher income households and all those presently in receipt of pension payments.

However, the welfare effects on lower income households are quite negative, with two large welfare losses attributable to cohorts aged 59 and 55 years in 2012 – the first generations of pensioners that must wait to receive a pension at 66 and 67, respectively.

In contrast, the increased taper policy has no impact on welfare of lower income households as they still qualify for a full age pension.

"We find that while these pension cuts deliver similar macroeconomic outcomes (increased aggregate labour supply and savings and reduced fiscal costs), strengthening the means test by lifting the taper has more equitable welfare implications," says Kudrna.

Tax hikes

Keeping the age pension policy settings unchanged but making changes to lift the consumption tax (GST), and/or progressive income taxes, and/or the payroll tax, can achieve a similar fiscal goal.

Again, "there is no surprise that young and future generations would be worse off by having to pay higher taxes over their entire life cycle and therefore would prefer pension cuts to mitigate the fiscal pressure," says Kudrna.

But modelling reveals that taxing either consumption or income results in opposing effects on the economy and welfare across different income groups of households.

Increases in the consumption tax rate have positive effects on labour supply, savings and GDP (similarly to pension cuts), but reduce the welfare of low-income households most.

Conversely, increases in progressive income or payroll taxes have negative effects on the economy but reduce the welfare of low-income households least.

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<h1>The retirement years: Who is going to pay?</h1>

<figure><img src="https://assets-us-01.kc-usercontent.com:443/4df0558d-5779-0012-00f2-b3fa06d6c950/25332dfd-459b-4a45-aef9-a9964b78f2af/Retirement%20Years%203.jpg?w=1320" alt="Retirement Years" /><figcaption>Retirement Years</figcaption></figure>
 Australia's latest Intergenerational Report (IGR) – the fourth since 2002 – leaves little doubt about the immense challenges we face from a population that is both changing and growing.
Not only are we living longer but there is also a demographic transformation occurring as the first of the baby boomers march beyond the official pension age of 65.
According to the report's projections, the number of Australians aged 65 years and over will more than double from present levels by 2054-55.
The number and proportion of Australians aged 85 years and over will grow even more rapidly. In 1974-75, this age group represented less than 1% of the population, or around 80,000 people. In 2054-55, it is projected that 4.9% of the population, or nearly two million Australians, will be aged 85 years and over.
The 2015 IGR also revised upward the previous estimates for the total population, which is expected to reach almost 40 million in 2054-55, with the growth supported by higher net overseas immigration than was assumed in past reports.   
Such changes in the size and age structure of the population during the next 40 years will have a fundamental impact on the economy, income growth and ultimately living standards.
George Kudrna, a research fellow at the Centre of Excellence in Population Ageing Research (CEPAR) at UNSW Business School, says the demographic transition towards population ageing can be expected to lead to decreases in aggregate labour market activity, resulting in a contraction in production and lower living standards compared to a world with no demographic change.     
Population ageing will also place increasing demands on government spending in the form of old-age related programs, including health, aged care and pensions.
The 2015 IGR projects that the spending on Age and Services Pensions will increase from 2.9% of GDP to 3.6% of GDP by 2054-55 under the "currently legislated" scenario, which includes increases in the pension age to 67 and the incremental lifting of the superannuation guarantee rate to 12%.
The aged care expenditures are projected to almost double during that period, contributing to an underlying fiscal deficit of 6% of GDP in 2054-55.
<blockquote>'Taxing either consumption or income results in opposing effects on the economy and welfare across different income groups of households'GEORGE KUDRNA</blockquote>
<h4>Behavioural responses</h4>
Kudrna's research paper, <a href="http://cepar.edu.au/media/145698/08_the_dynamic_fiscal_effects_of_demographic_shift.pdf">The Dynamic Fiscal Effects of Demographic Shift: The Case of Australia, </a>co-authored by UNSW Business School scientia professor Alan Woodland and ANU senior lecturer Chung Tran, also quantifies the fiscal challenges caused by demographic shift.
But an important difference from the IGR is that this CEPAR paper uses a general equilibrium model that incorporates behavioural responses by households to ageing.
According to Kudrna, in projecting the spending impact on an ageing population neither the IGR, nor an earlier report by the Productivity Commission on an Ageing Australia, took direct account of behavioural responses to population ageing.
"You would expect that people will respond to increased longevity by working and saving more during their life cycle," Kudrna says.
"We find that there are significant projection errors when abstracting from modelling such behavioural responses, which play an important role in explaining the impact of population ageing on the economy."
The authors also decompose the dynamic fiscal effect of population ageing by two sources of ageing – increased longevity and lower fertility – to determine their relative importance in the Australian context.
Their simulation results show that projected future changes in longevity are the main driving force behind such a pressing fiscal challenge. 
<h4>Policy options</h4>
Australia is recognised as one of few countries well placed to cope with population ageing pressure. Our retirement income policy features a low-cost, means-tested public pension and a privately managed, pre-funded superannuation scheme.
Also, we don't have to pay any specific labour income or payroll taxes, which in other developed countries are used to finance old-age and disability pensions.   
There is, however, no doubt that the government will face pressing fiscal challenges from the projected increases in the old-age related spending programs, which need addressing.       
Increasing the pension access age to 67 by 2023 – and possibly to 70 – has been an early response. Reduced spending on other areas such as defence has been raised as another option.
But what about cuts to the pension or increased taxes as policy options to mitigate the anticipated financial pressure? The IGR provides little guidance on who bears the costs of the proposed policies.
In their recent working paper,<a href="http://cepar.edu.au/media/148502/10_facing_demographic_challenges_-_pension_cuts_or_tax_hikes.pdf"> Facing Demographic Challenges: Pensions Cuts or Tax Hikes</a>, Kudrna, Tran and Woodland investigate the macroeconomic and welfare implications of the two fiscal policy options.
One of the main findings indicates that while both pension cuts and tax hikes achieve the same fiscal goal, the macroeconomic and welfare outcomes of the two policy options differ significantly.
<blockquote>'There should be no surprise that older people receiving the pension and those approaching the pension access age do not want their benefits cut and would prefer a tax hike to fund government spending commitments'GEORGE KUDRNA</blockquote>
<h4>Pension cuts</h4>
"There should be no surprise that older people receiving the pension and those approaching the pension access age do not want their benefits cut and would prefer a tax hike to fund government spending commitments," says Kudrna.
The authors consider three possible changes to pension benefits – a higher pension access age, a reduced maximum pension, and an increased taper of the pension income test (the rate at which the pension is withdrawn) – and study the effects on welfare of households distinguished by age and income type. 
Kudrna notes significant differences in the distributional welfare implications arising from the three options.
The higher pension age policy will have no impact on higher income households and all those presently in receipt of pension payments.
However, the welfare effects on lower income households are quite negative, with two large welfare losses attributable to cohorts aged 59 and 55 years in 2012 – the first generations of pensioners that must wait to receive a pension at 66 and 67, respectively.
In contrast, the increased taper policy has no impact on welfare of lower income households as they still qualify for a full age pension.
"We find that while these pension cuts deliver similar macroeconomic outcomes (increased aggregate labour supply and savings and reduced fiscal costs), strengthening the means test by lifting the taper has more equitable welfare implications," says Kudrna.
<h4>Tax hikes</h4>
Keeping the age pension policy settings unchanged but making changes to lift the consumption tax (GST), and/or progressive income taxes, and/or the payroll tax, can achieve a similar fiscal goal.
Again, "there is no surprise that young and future generations would be worse off by having to pay higher taxes over their entire life cycle and therefore would prefer pension cuts to mitigate the fiscal pressure," says Kudrna.
But modelling reveals that taxing either consumption or income results in opposing effects on the economy and welfare across different income groups of households.
Increases in the consumption tax rate have positive effects on labour supply, savings and GDP (similarly to pension cuts), but reduce the welfare of low-income households most.
Conversely, increases in progressive income or payroll taxes have negative effects on the economy but reduce the welfare of low-income households least.

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